As a result of the 2018 Tax Reform Act, Congress introduced a new section of the IRS code (Section 199A) that allows equity holders of pass through entities such as S corporations, LLCs, general partnerships, LLPs or sole proprietorships to deduct up to 20% of the “qualified business income” (QBI) against taxable income. Yet, there are special rules that relate to this new IRS code, specifically around how QBI is calculated and limitations around how much a taxpayer can deduct against taxable income on a personal tax return. Below are examples of what is excluded from the definition of QBI and some limitations to be eligible for a QBI deduction.
The definition of QBI excludes:
- Any net passive income for the current year.
- Suspended passive losses that do not reduce taxable income for over one year
- Suspended losses due to insufficient basis
Note: QBI losses in one year can be carried forward to a future year. Therefore QBI basis must be tracked year over year. It is also worthy to note that a QBI loss from one QBI business may be able to offset QBI from another qualified business.
Limitations of QBI deductions – The QBI deduction:
- Cannot reduce taxable income below zero (i.e. it can’t create an NOL on the return)
- Begins to phase out for married couples who have income greater than $315,000 and single filers with income greater than $157,500. QBI deduction goes away completely after taxable income reaches $415,000 and $207,500, for married couples and single filers respectively.
- May not be available to a taxpayer who is an equity holder of a “special services business”. According to Section 199A, the special services business may be one that is based on the reputation or skill of 1 or more of its employees. Sample special services businesses are ones that focus on: health, law, accounting, actuarial science, consulting, athletics, financial services, investment banking, brokerage services and securities trading. Engineering firms, architectural firms and manufacturing companies that generate a product are not considered special services businesses.
- Cannot exceed 50% of W-2 wages once the taxpayer exceeds the threshold
- Cannot exceed 25% of wages plus 2.5% of qualified property once the taxpayer exceeds the threshold
It is worthy to note this article is not meant to outline all of the rules that govern Section 199A. The purpose of this article is to identify issues brought forth as a result of Section 199A being introduced into the tax code that can impact the financial outcomes of a divorce. The above content simply provides some context for the content below.
Given the complexity of Section 199A, one should not assume you can simply deduct 20% of the qualified business income on your tax return. This would be an oversimplification and likely an overstatement of the potential tax benefits available.
How does this new law impact parties going through a divorce?
Section 199A is still fertile ground. It is subject to much interpretation, especially from a divorce perspective. When you view Section 199A in context to a divorce new issues arise that need to be addressed. Examples are as follows:
- Who is eligible to take the 20% QBI deduction on their tax return?
Is it the taxpayer who has a direct equity interest in the business, the spouse who does not have a direct equity interest or both? Intuition would guide someone to conclude the equity holder would be the only person eligible to take the deduction after the divorce is finalized. On the surface this sounds very logical. Yet, if the couple was not divorced before this law was passed then the couple can view this tax benefit as a deferred marital asset (i.e. a deferred tax asset) that will accumulate over time and should be allocated between the spouses. In short this becomes a hidden asset that needs to be tracked to design the right financial settlement structure for the divorce.
It is worthy to note, if divorcing parties have already finalized their settlement structure yet Section 199A creates a large tax benefit one or both divorcing parties may consider re-opening their divorce decree to potentially reap the financial benefits.
- Should the non-equity holder spouse have control over how the QBI is derived?
If one spouse possesses decision making authority in the business then that spouse, by definition, can influence the amount of QBI that may get generated in any single year. Its possible for the equity holder to defer QBI to later years and bypass the “Eligible Compensation Period” — the mutually agreed upon time horizon to share the tax benefit with the other spouse. If this occurred, should the spouse who does not own an equity interest have the right to:
- audit financial decisions of the business to understand how QBI is being generated
- set thresholds to ensure decisions are within acceptable boundaries
- ensure equity interests are not transferred to other parties during Eligible Compensation Period
Said differently, did Congress inadvertently introduce an element of the tax law to provide spouses who are not equity holders of pass through entity rights to say how the business will be run? Will spouses be able to dictate and define in the divorce decree the level of transparency needed from the business throughout the Eligible Compensation Period? Does this issue begin to blur the boundaries between personal and business?
Many people would say the spouse who is a non-equity holder would not be granted rights over the pass through entity’s business affairs. Trained professionals have shared this might be subject to debate creating opportunities for negotiation or causing divorcing parties to enter the court room to settle their financial differences.
Does the divorce decree need to clearly delineate terms and conditions as to how decisions are made to generate the QBI? This concept is similar, but very different from, how a commercial lender might place covenants on a borrower around spending limits, debt to equity ratios, changes of control, etc. This is something to be aware of when designing the financial settlement structure for parties going through a divorce.
- Can the 20% QBI deduction eligibility be split among two different returns?
This is another concern that does not have much guidance at this time. One could argue the reportable income and QBI deduction must stay together on the same return. This would align with what is commonly referred to as the matching concept in accounting. Yet, what happens if the profile of one taxpayer’s return disqualifies the use of a QBI deduction (e.g. the QBI deduction generates a taxable loss resulting in a carryover of the QBI to future years)? Should the QBI be subject to the other spouse’s tax profile to calculate the QBI deduction? If the QBI deduction is not available for the other spouse’s return should the divorcing parties agree to provide the compensation in another form?
It is worthy to note the AICPA has requested the IRS to provide clarity as to whether the QBI deduction can be split across different returns where one spouse is not a direct equity holder of the qualified business.
- Should Spouse 1 require Spouse 2 to use a specific entity structure for the business?
Taxpayers who are subject to phase out rules where taxable income has exceeded certain thresholds ($315,000 for MFJ and $157,500 for single filers, as defined above) can utilize W-2 wages to maximize the QBI deduction. Yet, most pass through entity structures except an S Corporation are restricted from issuing W-2s to its equity holders. As a result, should the spouse who does not have an equity interest in the business have decision making authority to force the conversion to a different entity structure?
- Should Spouse 1 require Spouse 2 to receive a W-2 throughout the Eligible Compensation Period?
Equity holders who utilize an S Corporation as their pass through entity structure may be eligible to maximize the QBI deduction after the threshold has been met based on 50% of the W-2 earnings or 25% of the W-2 earnings plus 2.5% of qualified business property that was used throughout the year or in existence at year end.
The equity holder of the business has decision making authority. He or she can decide whether to issue a W-2 to herself or himself. This decision making authority can influence whether the taxpayer will have the flexibility to maximize the QBI deduction. Given this fact, should Spouse 1 (the spouse that does not hold an equity interest) define in the divorce decree that Spouse 2 (the spouse that does hold an equity interest) must issue a W-2 throughout the Eligible Compensation Period to maximize the QBI deduction and resulting financial benefit? It is worthy to note: issuing a W-2 has different financial implications that may or may not outweigh the benefits of the QBI deduction.
- How long should the deferred tax asset be shared between the spouses?
The answer to this question depends on the current state of the business. If the business is in a state of growth, then it may prove beneficial to align the Eligible Compensation Period to the future tax benefit that could be derived as a result. In fact it might be beneficial to define more than one Eligible Compensation Period based on the attributes of the divorce. Said differently, you may have an Eligible Compensation Period for the deferred tax asset as opposed to an Eligible Compensation Period for different financial matters.
It is worthy to note that the AICPA has specifically asked that IRS to confirm that taxpayers may claim the QBI deduction even if they do not personally participate in the generation of QBI income.
- What if the IRS audits the QBI and determines the QBI calculation is inaccurate?
If this occurred the QBI deduction would be subject to change and could potentially impact each spouse’s liability. For example if the QBI inadvertently included guaranteed payments to partners or compensation for services performed by partners or employees of the business the IRS could determine the QBI is inaccurate and revise the tax liability for that year.
If Spouse 1 already received compensation from Spouse 2 as a result of the perceived tax benefit then Spouse 1 would be liable to Spouse 2 for monies inappropriately received due to a result of an inaccurate QBI calculation. It is worthy to note, if the divorce decree does not spell this out clearly the equity holder may be challenged to obtain the reimbursement from the non-equity holder spouse.
- Does a QBI loss that is carried over to future years have value to a divorcing party?
This issue is similar to how an NOL carry forward is handled on a tax return and in context to a divorce decree. So, the answer is Yes and should be incorporated into the financial settlement structure.
- What happens when both spouses are equity holders of different businesses?
In these situations the spouses may be eligible for two different QBI deductions. The best thing to do is to figure out how the QBI deduction should be allocated between the spouses, the length of the Eligible Compensation Period, how the QBI deduction in the aggregate needs to be handled in context to the available taxable income for one or both spouses.
It is worthy to note there are at least three questions awaiting IRS guidance:
- Can wages paid by an employee leasing company qualify for the QBI deduction?
- What happens when an owner has a fiscal year of a pass-through entity ending in 2018?
- Is the QBI deduction available for electing small business trusts (ESBTs)?
Where one or both divorcing parties are equity holders of a business the divorce decree should take these types of issues into account. It would be wise for divorcing parties who are planning to get a divorce or are in the midst of one to think through how to best account for the deferred tax asset in the overall financial settlement structure.
About the Author
Larry Smith is a Founding Partner of Divorce Outcomes, a specialized professional services firm that manages all of the financial aspects in a divorce process. Since 2003 he has worked as a trusted financial advisor, financial advocate, divorce architect and technical financial expert; he is not an attorney. He is an alumni of KPMG and Andersen with expertise in technical accounting, forensics, sophisticated taxation, management consulting, risk management, advanced process engineering, business combinations, divorce management, multi-party negotiations, advanced quality analytics and cognitive performance technologies. Since 1986 Larry has been advising individuals and organizations about innovative financial solutions to resolve complex financial challenges that arise in life and in business.
For both personal and business divorces, Larry is considered an expert in divorce strategies, divorce process management, financial divorce architecture, financial risk management, taxation for divorces, financial divorce forensics, advanced divorce analytics, financial divorce negotiations and mediation, business valuations and sophisticated equity structures. He helps clients shape complex financial decisions, manage communication risks and ever-changing negotiating positions to strategically preserve or grow wealth from these types of transactions.
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About Divorce Outcomes
Divorce Outcomes is a specialty services firm that helps people both domestically and internationally manage all of the financial decisions that arise in their divorce process. We are not attorneys. We are financial experts who partner with our clients as their personal financial advocates. We help our clients manage their divorce process, uncover hidden financial risks, architect divorce solutions, manage ever-changing negotiating positions, communicate complex financial matters and close the divorce process as soon as possible with a goal to arrive at the best outcomes possible. Throughout the process we evaluate the current state of our clients’ financial lives with an objective to best reposition their future. We do not sell any products. We simply raise issues that are in our clients best interest. Our clients share with us we:
- unfold, analyze and repackage their financial life so they are well positioned after their divorce
- preserve the value of their business or marital estate
- continuously strive to provide a return on our services
- build balanced financial solutions grounded in evidence
- find ways to make our client, and at times both parties, money through the process
- design their divorce to work for them and their family’s life
- provide mental clarity to make decisions
- reduce the total process time from start to close
- minimize the stress and unpleasant memories that can last a lifetime
As we reach an agreed upon settlement structure, we help our clients identify a fitting attorney who can leverage the financial solution to draft and record the requisite legal documents. Where outcomes are at risk from a traditional process, we function as expert financial negotiators or financial mediators to turn around the situation and achieve our client’s desired outcomes.
This communication is for general informational purposes only which may or may not reflect the most current developments. It is not intended to constitute formal advice or a recommended course of action as every person’s situation is unique and different. The information here is not intended to be, and should not be, relied upon by the recipient to make a decision without professional guidance.